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Relative Scarcity of Commodities with a Long-Term Economic Relationship and the Correlation of Futures Returns

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  • Jaime Casassus
  • Peng Liu
  • Ke Tang

Abstract

This paper finds that the long-term co-movement of commodity prices is driven by economic relationships, such as production, substitution, and complementary relationships. Such relationships imply that the convenience yield of a given commodity depends on its relative scarcity with respect to associated commodities. The economic linkage between two commodities creates a new source of positive correlation between the futures returns of both commodities. We build an empirical, multi-commodity maximal affine model that allows the convenience yield of a commodity to depend on its relative scarcity. We estimate the model using three commodity pairs: heating oil-crude oil, WTI-Brent crude oil and heating oil-gasoline. Our model allows for a flexible correlation term structure of futures returns that matches the upward-sloping patterns observed in the data. The high long-term correlation implied by an economic relationship reduces the volatility of the spread between commodities, which implies lower spread option prices. An out-of-sample test using short-maturity crack spread options data shows that our model considerably reduces the negative bias generated by traditional models.

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Bibliographic Info

Paper provided by Instituto de Economia. Pontificia Universidad Católica de Chile. in its series Documentos de Trabajo with number 404.

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Date of creation: 2011
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Handle: RePEc:ioe:doctra:404

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Keywords: Relative scarcity; correlation term structure; futures returns; long-term economic relation-ships; convenience yield; feedback effect; multi-commodity maximal affine; spread option;

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  12. Jaime Casassus & Pierre Collin-Dufresne, 2005. "Stochastic Convenience Yield Implied from Commodity Futures and Interest Rates," Journal of Finance, American Finance Association, vol. 60(5), pages 2283-2331, October.
  13. Dempster, M.A.H. & Medova, Elena & Tang, Ke, 2008. "Long term spread option valuation and hedging," Journal of Banking & Finance, Elsevier, vol. 32(12), pages 2530-2540, December.
  14. Banerjee, Anindya & Dolado, Juan J. & Galbraith, John W. & Hendry, David, 1993. "Co-integration, Error Correction, and the Econometric Analysis of Non-Stationary Data," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780198288107, October.
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  18. Schwartz, Eduardo S, 1997. " The Stochastic Behavior of Commodity Prices: Implications for Valuation and Hedging," Journal of Finance, American Finance Association, vol. 52(3), pages 923-73, July.
  19. Jaime Casassus & Pierre Collin-Dufresne & Bryan R. Routledge, 2005. "Equilibrium Commodity Prices with Irreversible Investment and Non-Linear Technology," NBER Working Papers 11864, National Bureau of Economic Research, Inc.
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